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Sunday, October 3, 2010

What to Do About the Flash Crash?

The Oct. 1, 2010 joint SEC-CFTC report on the May 6, 2010 flash crash revealed that the market plunge was triggered by a single large sell order in a derivatives contract called the E-Mini, which is a futures contract that tracks the S&P 500 index. The story from the report, which is summarized here, is that the big sell order, placed by a mutual fund complex after the market had fallen about 4%, was for 75,000 contracts, having a value of around $4 billion. The mutual fund complex, unnamed in the report, wanted to hedge a large existing stock market position. It apparently hoped that selling the E-Mini contracts would protect its investors from further loss if the market continued to fall.

The mutual fund complex, which hasn't been officially identified although only those without Internet access can't figure out its probable identity, chose a automated computer execution process based on an algorithm that simply sent out the amount of orders it calculated to be 9% of the previous minute's trading volume. These orders were placed without regard price or time. That made the algorithm insensitive to the impact its orders might have on the market. It was an automaton that simply measured the preceding trading volume and pumped out 9% of that volume in new orders. If trading volume fell, the number of new sell orders the algorithm would send out would fall. If volume rose, so would quantity of new sell orders the algorithm issued.

The early sales from the 75,000 contract E-Mini sell order were purchased by other institutional investors, mostly high speed traders that don't hold their purchases for very long. As more sell orders came in from the algorithm, the early purchasers got nervous about the E-Mini contracts they'd already purchased and tried to sell them. Thus, they added to the trading volume generated by the algorithm's sales. The algorithm took this increased trading volume as a signal to place even more sell orders (since 9% of a larger number calls for more orders than 9% of a smaller number).

Buying interest, however, shrank as more and more E-Mini sell orders came on the market. Some high frequency traders began to buy and sell from each other, because there were fewer and fewer other buyers. But that only increased trading volume, which led the algorithm to dump yet more sell orders onto the market. This only made things worse.

Some of the traders buying E-Minis sold individual S&P 500 stocks to hedge themselves (i.e., to limit their risk from holding E-Minis). This put downward pressure on stocks, which led to the plunge that the investing public saw.

It was not until a computer system at the Chicago Mercantile Exchange, where the E-Mini contract is traded, implemented a temporary trading halt that the downward motion of the derviatives market was stopped. When trading resumed five seconds later (a long time in the world of computerized trading), E-Mini prices stabilized and then rose. The algorithm actually sold some contracts into this rising market.

Meanwhile, back at the ranch, stocks were still plunging. The early stock price drops had triggered more sell orders, as traders and their computers far and wide interpreted the market volatility as a signal to bail out. Buying interest exited stage right, exacerbating price plunges. Some stock sell orders were executed for a penny per share. Eventually, trades more than 60% above or below the 2:40 p.m. prices (which the exchanges and FINRA, a stock market regulator, deemed to be pre-lunacy prices), were cancelled. Why 60%? It's not very clear in the report.

Although the flash crash was over very quickly, it produced a intraday drop of 5-6% in stock prices (on top of a 4% drop that had already occurred that day). This scared the bejesus out of many investors, especially individuals, who subsequently moved more money out of stocks and into bonds even though bonds have absurdly low yields.

The report doesn't include any prescriptions for the future. No doubt, the SEC's and CFTC's enforcement divisions are sniffing around for violations of law. But there is scant indication in the report that anyone in either agency sees a likelihood of enforcement action. A crucial question is why did the selling mutual fund complex choose an algorithm that issued sell orders based on trading volume only, without any assessment of price impact and without regard to how quickly its orders were landing in the market. It had previously sold such a large quantity of E-Mini's, but much more slowly and without the sudden price drops. The report doesn't cast any light on the seller's thinking.

Based on the information available to date, there is a serious chance that neither the SEC nor CFTC will do anything on the enforcement front. On the regulatory front, the SEC has approved tighter triggers for trading halts. Sudden price moves in the most frequently traded stocks of 10% or more within a period of five minutes now result in a 5-minute trading halt. The SEC has also tried to make the process of canceling trades at seemingly off-market prices more transparent.

But the SEC and CFTC don't seem to think they can prevent another flash crash. At least, if they think they can, they surely didn't make that point in the report. Realistically, it would be quite difficult for them to "prevent" another flash crash, because they'd have to control the volume of orders reaching the market, trying in some way to balance buying interest with selling interest. Any such effort by the government would be destined to failure, as it would require the government to define supply and demand, fundamental market forces that governments can't effectively define. So it seems that the regulators can only soften the impact of future flash crashes.

So is there no legal consequence? A large institutional investor can just wallop the market and everyone who is clobbered learns the hard way that passbook savings are so bad?

There may be an answer in the history of American business. About 150 years ago, businesses began incorporating under newly enacted state laws that allowed anyone to create a corporation. Because the corporate form of business protected investors from unlimited personal legal liability for the business's liabilities, it became the dominant form of business enterprise. Incorporated businesses attracted large amounts of capital and grew quickly. Their reach became regional and then national. Companies in one state sold products to customers in other states 2,000 or even 3,000 miles away.

Some of these products were shoddy or defective. When customers tried to sue, they were hindered by a variety of legal doctrines, some of which dated back to medieval English law. Many state legislatures and some state courts took steps to modernize the law, resulting in the evolution of today's law of products liability. This body of law is based on principles that lawyers call "tort law," which hold that a person who is negligent can have civil monetary liability for the foreseeable consequences of his or her acts, even if the person didn't intend to cause injury. For example, early in the 20th century, courts began to hold auto manufacturers liable for defects in cars, even when they were thousands of miles away and didn't directly sell the car to the injured person. This was an outcome that the courts of the Civil War era would have considered unspeakable. But it quickly became the law of the land when commerce grew to be national in scope.

The financial markets have evolved way beyond the current legal structure. And the snail's pace of legislative reform, with the Dodd-Frank Act coming two years after the financial crisis of 2008, offers little hope that the top-down government regulation of the financial markets from Washington will keep pace. Maybe it's time to think about applying the principles of tort law to players in the financial markets. The mutual fund complex that evidently triggered the flash crash chose a forceful way of executing a massive quantity of sell orders in the E-Mini that it perhaps should have foreseen would cause disruption, chaos and losses to innocent investors. The threat of financial liability for losses and damage might well make market players pause and think before using potentially injurious trading tools.

A major advantage of applying tort law is that it doesn't try to regulate conduct. It creates liability that leads people to regulate their own conduct. Tort law applies to drivers on the roads. While many drivers don't seem to believe in scrupulous adherence to the rules of the road, almost all drivers try in their own way to be careful because an accident that injures others can lead to a jump in their insurance premiums. In other words, negligence costs them money so they exercise care.

Many on Wall Street would be aghast at the idea of tort law being applied to financial market players. The liabilities, they might proclaim, would destroy the financial system. But the same arguments could have been made about products liability law being applied to auto companies and all manner of other manufacturers. In general, that hasn't happened. And when it threatened, many companies ducked into bankruptcy court and worked out ways to compensate injured persons while continuing as businesses. The courts applied tort law in measured ways that allowed injured persons to obtain recompense without destroying American commerce.

The threat of tort liability to actors in the financial market could lead them to monitor and moderate their behavior. No government would tell them how to trade. They would decide for themselves how to trade. But they couldn't think only about themselves. They'd have to be concerned about smacking the corn flakes out of other market participants. Tort liability would motivate them to design and use trading algorithms and other trading tools in kinder and gentler ways, making the markets a better and safer experience for all.

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